CHAPTER 17 Financial statement analysis II. Contents. Introduction – Framing of financial statement analysis Quality of earnings Analytical techniques Strategic ratio analysis Z scores Shareholder value. Framing of financial statement analysis.
Sovereign macro-economic analysis
Industry sector analysis
Regulatory environment (national and global)
Competitive trends in sector
Quantitative analysis financial statements past performance future projections
Qualitative analysis management strategic direction financial flexibility
Some analysts will compare, in a longitudinal fashion, operating profit to net operating cash flow to identify and analyse the effect of ‘accruals’- games on operating earnings.
(a) Is disposed of or terminated pursuant to a single plan
(b) Represents a separate major line of business or geographical area of operations, and
(c) Can be distinguished operationally and for financial reporting purposes.
Source: IFRS 5 – Non-current assets held for sale and discontinued operations, Guidance on implementing
ROE x (1 – Dividend payout ratio)
= indicator of internally generated growth potential if the company’s profitability, dividend payout and level of debt financing are kept constant
There is a conventional relationship between management performance ratios which links return on investment, profit margin and asset turnover as follows:
Profit margin * Asset turnover = ROI
If we apply this reasoning to the ROA (return on assets) ratio, we arrive at the following algebraic equality:
Assume: ROA decreases over a number of periods
Assume: Asset turnover drops => Cause? Sales, assets or both?
Assume: Profit margin decreases => Cause ?
Increasing operating expenses, decreasing market share, decreasing sales prices, …
Taking the analysis one step further, the return on equity can be analytically linked to the return on assets ratio with the introduction the concept of financial leverage.
ROA * Financial leverage = ROE
Starting with the ROA (return on assets) ratio, we arrive at the following algebraic equality:
Alternatively, we can start from the original ROE definition and get the following:
A related, but somewhat different, concept is the financial leverage coefficient ratio, defined as ROE divided by ROA:
Financial leverage coefficient = ROE% / ROA%
Combining ROI decomposition and financial leverage brings us to the following overall model (also called the DuPont model):
ROE = Net profit margin * Asset turnover * Financial leverage
Costs = Fixed + Variable Costs
If sales increase by 10%, profit before tax of company A increases by 30% and profit of company B by 80%
A decrease in sales will have a more dramatic effect in company B
2 samples with mutual matching of which one with failed companies - data consist of financial ratios relative to years before failure => ratios which discriminate best between two groups are used as input for failure prediction models
The essence of present value is that a rational person will prefer to have a receipt sooner rather than later because the money can be used to generate more money.
For example, if a company has a choice of receiving $1,000 now or $1,000 in a year’s time, it would prefer to have the cash now because it could be invested and earn a return. If the money was put into risk free securities where it could earn 15 per cent, then $1,000 now would be worth $1,150 in a year’s time.
Extending that, the $1,000 to be received after a year is worth $1,000/1.15 (or $870) today, because $870 invested today at 15 per cent would yield $1,000 in a year’s time. Similarly, $1,000 to be received in two years’ time is worth $1,000/(1.15*1.15) = $756 at present (i.e. compound interest at 15 per cent for two years would be $244).